By Randall A. Denha, Esq.*
Is there anything worse than being taxed on income you receive? Having to pay tax on income you never actually collect. That can happen if a family member borrows money from you on an interest-free basis. If you’re not careful, you could owe tax on this “phantom income.”
Fortunately, this harsh tax result can be avoided by staying within the tax law boundaries. The basic rule is that, if the borrower in an intra-family loan pays no interest, or interest at a below-market rate, interest income is imputed to the lender. In effect, the lender is first treated as having charged interest and then gifting the interest to the borrower. The borrower is then considered to have used the gifted interest to pay the lender. This results in tax on the imputed interest.
Fortunately, there are two key exceptions in the tax law:
- Under a “de-minimis rule,” there’s no tax due if the loan totals $10,000 or less as long as the funds aren’t used to purchase income-producing assets.
- Rest imputed to the lender annually for tax purposes is limited to the borrower’s net investment income for the year. And, if the borrower’s net investment income doesn’t exceed $1,000, the lender need not declare any imputed income at all.
Finally, you can avoid the entire issue by simply charging a reasonable interest rate. Use the Applicable Federal Rate (AFR) published by the IRS for the month of the loan.
*RANDALL A. DENHA, J.D,, LL.M., principal and founder of the law firm of Denha & Associates, PLLC with offices in Birmingham, MI and West Bloomfield, MI. Mr. Denha continues to be recognized as a “Super Lawyer” by Michigan Super Lawyers in the areas of Trusts and Estates Law; a “Top Lawyer” by D Business Magazine in the areas of Estate Planning and Tax Law; a Five Star Wealth Planning Professional; Michigan Top Lawyer; New York Times Top Attorney in Michigan and a Lawyer of Distinction in the areas of Estate and Tax Planning. Mr. Denha can be reached at 248-265-4100 or by email at firstname.lastname@example.org